November 27, 2008

The recession the world has now entered is deepening. It is no mere passing phase.

It may have been started by US housing loans going bad, but the problem for the whole world is much greater than a trillion dollars or so of dodgy US housing loans.

So far, we in Australia have taken comfort from the fact that the US situation is unique in many respects. We are fortunate in that we don’t have the equivalent of the Community Reinvestment Act, a toxic piece of legislation that mandates loans to high-risk borrowers. We don’t have the Association of Community Organizations for Reform Now (ACORN) to pressurise financial institutions to grant such loans. We don’t have government-sponsored organizations (GSEs) such as the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac), both of which were protected politically from proper supervision, to sanitise dodgy loans.

We are also fortunate in that we don’t have non-recourse loans, loans under which the borrower is in effect provided with a put option to sell the mortgaged property to the lender for the balance owing on the loan. We are thus spared a major moral hazard in a declining market.

For years, Americans have saved too little and borrowed too much. Hooked on consumption, they have relied on foreigners to make up their savings deficiency. Now it’s caught up with them, and with those who lent to them.

In both Europe and America, banks are being bailed out left and right, the latest being the giant Citigroup. When you consider that banks are the most financially geared organizations on earth, this is hardly surprising. Even a conservative bank, with a gearing of twenty to one, only requires five percent of its loans to go bad to lose its entire capital, and some banks were geared as high as sixty to one.

Here in Australia, we are fortunate that the previous Federal Government paid off debt and built a future fund, but we shouldn’t feel too superior. The Americans were not alone in their failure to save. For years, our net savings have been low, sometimes even negative. We too relied on foreigners, not our own savings, to provide much of the finance for our houses, our industry and our commerce.

Clearly this was not sustainable. The economy was out of balance. But it worked for a time. Just as in the US, housing prices rose and the stock market boomed. We could shop until we dropped yet still be wealthier at the end of each year than at the beginning.

Now it has caught up with us and we’re all a lot less wealthy.

Older people are less wealthy because the value of their investment in superannuation has declined by up to 40%. Younger people are less wealthy because while their mortgages may be unchanged, the value of homes so financed has declined. Business people are concerned that they may lose everything if their business income proves insufficient to service their debts.

Of course, any changes in behaviour will depend on a person’s position to start with. The very poor already don’t save much as they have little to spare, so there won’t be much change in their behaviour. Provided they are not excessively geared, the behaviour of the very rich also won’t change much. They may economise by merely buying a new Bentley Continental Flying Spur and deferring the Learjet, but this will make little overall difference – there aren’t enough of them for that.

It is those in the middle – neither poor nor rich, but many also shareholders in public companies – who will be most concerned about the loss of wealth, even though they may not yet have experienced any actual loss of income.

Just as banks in Europe and the US must now recapitalise their balance sheets, people in the middle will also feel the need to improve their own personal balance sheets. They have the flexibility to adjust their expenditure patterns and this they will now do. They will spend less on holidays and home entertainment systems and keep the old car. Overall, their consumption will decline and their savings will increase until they are once again comfortable with their financial situation. Only then will a new equilibrium be reached.

This will take time, and government actions can either help or hinder this process.

Unfortunately, the government’s approach so far is to throw money around in the hope that people will be persuaded to continue to consume. The Federal Government’s recent gift to local government is an example of this.

But this ignores the fundamental problem – the drop in personal wealth. If governments want to help, the best thing they can do is give substantial tax cuts to help speed the rectification of personal balance sheets.

Eventually recovery will occur, but given the nature and size of the imbalances throughout the world, it will probably take at least five years. It will take less time if citizens are permitted to control their own expenditure and more time if governments in effect assert that they know how to spend your money better than you do.

November 21, 2008

In spite of all the efforts of governments and central banks worldwide, a broad credit contraction is underway and it will continue until savings start to grow again. There is some muddled talk about money printing leading to hyperinflation. It is perfectly true that central banks are pumping money like there is no tomorrow into the banking system, and politicians seem hell-bent on propping up failed companies such as GM, Ford and Chrysler with direct loans, but authorities cannot force banks to lend, nor people to borrow. This is what is termed, 'pushing on a string.' Historically, there appears to be an inverse relationship between the money base and broader credit aggregates. Following the 1929 crash, expansion of the money base accompanied credit contraction. Then, as now, the Federal Reserve was seeking to fight the contraction.

As economists of the Austrian School have argued, the problem is not the bust, but the preceding boom. The current deflation, like all previous deflations, will continue until equilibrium is restored between savings and the demand for credit. Governments and central bankers may claim that this time it will all be different. Yet all their efforts to boost consumption and attack thrift are only replays of old delusions. In the real world, Mr Market and Mr Margin Clerk continue to hold sway.

November 06, 2008

The Baltic Dry Index has now fallen to 815. Back in June, 2008, it stood at 11,793. In any language, this is a massive contraction in the movement of raw materials for manufacturing. Currently, fund managers and other stock market participants are paying no heed. I am not a forecaster, but one might observe that bear markets, in their early stages, are crowded with optimists.

Here are the latest "Big Money" poll results as reported by Barrons for Monday November 3:

To exist, you need an ideology. The question is whether it is accurate or not. And what I'm saying to you is that I found a flaw - I don't know how significant or permanent it is - but I've been very distressed by that fact...I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works.

I, like Tyler Cowen, am not quite sure what Greenspan conceded here. However, he leaves open the possibility of people interpreting his words as a requiem for capitalism.

The ideological champion of new atheism and the ideological champion of free markets have given the impression that they have serious reservations about their ideologies.

"The question is whether [your ideology] is accurate or not". I remain convinced that laissez-faire is the best model for economics and theism the best model for belief and life. The current financial market perturbations, pace Greenspan's comments, does not shake my belief in the former. However, Dawkins' Concession is one more (minor) data point for belief in the latter.

We are living in times where governing ideologies are coming under sustained attack. Change we can believe in?

September 22, 2008

I've been intrigued as to why banking directors haven't resorted to the age-old method of "director's valuations" to value their hard-to-value MBS and CDOs. And apparently, as I found out today, it is because the accounting standards do not allow them to do so. And mark-to-model is last in the accounting hierarchy of:

1) market price;
2) last traded price of similar instrument; or
3) mark-to-model.

My understanding is that because Merrill Lynch sold a bunch of CDO holdings at fire sale prices a few weeks ago, NAB had to follow suit and revised the value of similar holdings down (see number 2 above). That's just a vicious cycle.

This is just stupid. If governments can suspend short-selling and delay trading on a public exchange for an hour (as they did in Australia today), why can't they suspend mandatory mark-to-market for 12 months until the market stabilises (with a clear definition of stability)? Instead, governments are pumping billions into money markets and U.S. taxpayers will be on the hook to the tune of a trillion dollars to bailing out failing/flailing financial institutions.

The more I think about it, the more I think the world isn't going broke, if by broke we mean that the "true" value of assets are less than the "true" value of liabilities. At the moment, no one is trading any of the "toxic instruments" we are terrified of. As a result market prices are opaque and being further muddied by stupid restrictions on short sales and accounting mandated write downs that are forcing dead positions to be crystalised at silly prices (starting the whole cycle again). And lets not forget lots of panic.

The other note I would like to make is that we haven't heard a cogent argument from Paulson or Bernacke about why their massive bailout is needed. Why the rush? Why the size? Someone explain? For example, late this afternoon (Sydney time), Bloomberg was reporting that Treasury had requested that it be able to use the $800bn to buy whatever they liked (rather than it being restricted to mortgage related securities). Oh and they would like more money thanks. No explanation. Nothing. The government mandates that publicly listed companies continuous disclose to the market material information. But apparently it doesn't apply that them.

Implementation of the Paulson plan is going to be a mess. It is going to be a great opportunity for lobbyists and lawyers to make a lot of money. Who are the financial magicians Paulson is going to hire [to run the massive $800bn behemoth]? Are they from Wall Street? If they’re from Wall Street, aren't they the very people we are saving? And doesn’t that mean that we’re using the taxpayers’ money to hire people to save their friends with even more taxpayer money? Won't this inevitably lead to crony capitalism?

September 21, 2008

Roderick T. Long over at the art of the possible blog has posted a challenge to the popularly held notion that the United States of the 19th century was a free market utopia:

Every part of this story is false. To begin with, there never was anything remotely like a period of laissez-faire in American history (at least not if “laissez-faire” means “let the market operate freely” as opposed to “let the rich and powerful help themselves to other people’s property”). The regulatory state was deeply involved from the start, particularly in the banking and currency industries and in the assignment of property titles to land.

Read the whole thing. But in essence, the article argues that far from opposing regulation, business - particularly big business - have been strong proponents of regulation. The rather cogent argument presented by Long is that an unregulated monopoly/oligopoly is likely at attract greater competition due to the premiums it can demand from the market. This extra competition drive prices down as the monopolist/oligopolist loses their pricing power. That is why business prefer legal monopolies/oligopolies. Industries and sectors that can lobby for government regulation that keeps competition out, will entrench existing businesses' pricing power.

Long argues that these same businesses publicly rail against government intervention to maintain a thin veneer of protest and to give politicians the cover needed to enact these regulations.

That this should be so is not terribly surprising; wealthy, concentrated interests are inevitably going to have a greater impact on the political process than poorer and more dispersed ones. (Contrary to popular wisdom, which has the contrast gong the other way, it is only on the market, where the price system aggregates the preferences of the poorer and more dispersed, that the latter can systematically trounce the influence of business power.) What is more surprising is that such blatantly and thoroughgoingly pro-business legislation should have been perceived as anti-business. [emphasis mine]

However, I would dispute Long's account of business' duplicity with regards to regulation - at least as evidenced contemporaneously. Take business and their response to the pressure that has been building up over the last decade to enact a (global) carbon tax. For some time, earlier in the 1990s, business strenuously argued against it (profits would fall, jobs lost, capital investments mothballed, etc). Recently their tune has changed - even within the industries most affected. Consider the mining industry. Most mining companies are now not putting up a fight against the idea of a carbon tax. In fact, their annual reports and TV advertisements gloat about how environmentally friendly their operations are and the extent to which environmental risk mitigation strategies are incorporated into their business models. When the government is willing to shower business with free money, subsidies, I don't blame them.

It was only this week, that the Federal government announced a $A100m research centre that will fund research into carbon, capture and storage in league with the major energy companies. And only a few months after the Federal government handed out another $A35m to Toyota to research and build a green car in Australia which they were going to build here anyway. These regulations and subsidies increase the barriers to entry for new participants, or more pertinently, the production of complementary goods and services, maintain oligopolies' market power.

And if ever there were a clearer example of government supporting the anti-competitive practice of business, then it is the US Treasury's bail out of financial powerhouses drunk on their recent success not noticing the cliff that lay ahead. The Treasury Secretary was the former head of Goldman Sachs. He had brought over quite a few of his old IB mates to the Treasury. It should therefore not surprise observers that Paulson argued a catastrophe was facing financial markets were he not to receive carte blanche powers to distribute $US800bn + to ailing IBs and financial institutions. Part of me doesn't doubt the truthfulness of Paulson's argument - markets are manic and no trust is in the system. However, the cynic in me isn't satisfied. Arnold Kling fuels the cynic's fire.

September 15, 2008

First a disclaimer. If you act on anything I write below, you are a goose. These are, as the title suggests, notes on the shockwave rippling through the global financial system. Not advice. Not investment tips. Go see your broker at Lehman Brothers or Merrill Lynch for that.

The Federal Reserve and U.S. Treasury Department have refused to step in and save Lehmann. They refused to buy them out (like they did with Freddie and Fannie) or provide cheap financing or guarantees for potential suitors (like they did with Bear Sterns). Namely, they turned to the big banks and said, "Enough work on our part. Your turn." Contrary to what you might read in the AFR tomorrow morning, this is a good thing. And it is a good thing because we are seeing moral hazard rush out of the financial system. This is going to cause some short term pain as everyone adjusts, but long term, this is a good thing.

It is interesting to observe Jim Rogers urging all and sundry to get out of the US Dollar just after it had made that March low. Yet, it appears that the declining US Dollar had been inversely related to economic expansion and credit growth over the last few years.

A close perusal of the first link shows that US broad money growth peaked out shortly before the US Dollar made its March low. Now that the broad money growth has collapsed, may we expect the upward trend of the US Dollar, now seemingly well established, to continue?

If US housing and other asset prices continue to decline, it seems logical to expect that broad money will continue to shrink, notwithstanding all the efforts to sustain bank liquidity via repurchase agreements and borrowings at the Federal Reserve discount window. In the context of diminishing collateral to sustain borrowing, a stronger US Dollar paradoxically portends bad news on the deflation front.